2.4 Financial markets and monetary policy Flashcards
Monetary policy
the manipulation by government of monetary variables such as interest rates, money supply, and exchange rates to achieve its policy objectives
policy instrument
a tool or set of tools used to try and achieve a policy objective
central bank
a national bank that provides financial and banking services for its country’s government and banking system, as well as implementing the government’s monetary policy and issuing currency
Bank of England
the central bank of the UK
monetary policy committee (MPC)
nine economists, chaired by the governor of the bank of England, who meet once a month to set the Bank Rate and whether other aspects of monetary policy need changing
inflation rate target
the CPI inflation target set by the government for the Bank of England to achieve. The target is currently 2%
Bank rate (base rate of interest)
the rate of interest that the Bank of England pays to commercial banks on their deposits held at the Bank of England
Lender of last resort
the institution in a financial system that acts as the provider of liquidity to a financial institution which finds itself unable to obtain sufficient liquidity when all other sources have been exhausted. It is, in effect, a government guarantee of liquidity to financial institutions
Hot money
highly volatile money derived from investors storing money in different institutions, looking for the highest rate of return
money supply
the stock of money in the economy, made up of cash and bank deposits, at a particular point in time
Contractionary policies
policies aimed at reducing Aggregate Demand
Expansionary policies
policies aimed at increasing aggregate demand
monetary policy instruments
the tools the MPC has to achieve policy objectives. The main monetary policy instrument that the MPC has is the bank rate. There are other less conventional monetary policy instruments, such as quantative easing
Contractionary monetary policy
uses higher interest rates to decrease aggregate demand and shift the AD curve to the left
Describe contractionary monetary policy
- increase in bank rate
- causes an increase in exchange rate, imports are cheaper so (X-M)↓, AD↓
- causes an increase in the market rate of interest, reward for saving increases and cost of borrowing increases, so C↓ and I↓, AD↓
Expansionary monetary policy
uses lower interest rates to increase aggregate demand and to shift the AD curve to the right
Describe expansionary monetary policy
- decrease in bank rate
- causes a fall in the exchange rate, imports more expensive, (X-M)↑, AD↑
- causes a fall in market rate of interest, reward for saving decreases and cost of borrowing decreases, so C↑ and I↑, AD↑
Exchange rate
the external price of a currency, usually measured against another currency
SPICED
Strong Pound Imports Cheaper Exports Dearer
Describe the relationship between interest rates and the exchange rate
- a fall in UK interest rates causes financial capital to flow out of the pound and into other currencies in search of better rates of return
- this reduces demand for pounds and increases the supply of pounds on the foreign exchange market, causing the pound’s exchange rate to fall
- This reduces UK export prices and increases import prices.
Factors considered by the MPC when setting the bank rate (5)
- unemployment rate
- savings ratio
- consumer spending
- commodity prices
- exchange rate
Impacts of a fall in the exchange rate on AD and policy objectives (2)
- A reduction in the exchange rate causes exports to become cheaper, which increases exports. This assumes that demand for exports is price elastic. It also causes imports to become relatively expensive. This means the UK current account deficit would improve.
- However, this is inflationary due to the increase in the price of imported raw materials. Production costs for firms increase, which causes cost-push inflation.
Transmission mechanism of monetary policy
the process by which alterations to the base rate affect determinants of aggregate demand
Functions of money (4)
- medium of exchange
- measure of value
- store of value
- standard of deferred payment
Characteristics of money (6)
- acceptable
- portable
- durable
- divisible
- limited in supply
- difficult to forge
How does money solve problems created by bartering?
- without money, transactions were conducted through bartering.
- Goods and services were traded with other goods and services, but people did not always get exactly what they wanted or needed.
- The goods and services exchanged were not always of the same value, which also posed a problem. Exchange could only take place if there was a double coincidence of wants, i.e. both parties have to want the good the other party offer.
- Using money eliminates this problem.
Describe money as a measure of value
Money provides a means to measure the relative values of different goods and services.
Describe money as a store of value
- Money has to hold its value to be used for payment.
- It can be kept for a long time without expiring.
- However, the quantity of goods and services that can be bought with money fluctuates slightly with the forces of supply and demand.
Describe money as a standard of deferred payment
- Money can allow for debts to be created.
- People can therefore pay for things without having money in the present, and can pay for it later.
- This relies on money storing its value
Narrow money
the part of the stock of money (or money supply) made of cash and liquid bank and building society deposits.
Broad money
the part of the stock of money (or money supply) made of cash, other liquid assets such as bank and building society deposits, but also some less liquid assets. The measure of broad money used by the bank of England is called M4
Liquidity
measures the ease with which an asset can be converted into cash without loss of value. Cash is the most liquid of all assets
Equity
equity is wealth: shares are known as equities. However, equity can also mean fairness or justness: it depends on the context in which the term is is used.
Debt
money people owe
Financial markets
markets in which financial assets or securities are traded
Roles of financial markets (5)
- To facilitate saving
- To lend to businesses and individuals
- To facilitate the exchange of goods and services
- To provide forward markets in currencies and commodities
- To provide a market for equities
Bonds
financial securities sold by companies (corporate bonds) or by governments (government bonds) which are a form of long term borrowing. Bonds usually have a maturity date on which they are redeemed, with the borrower usually making a fixed interest payment each year until the bond matures.
Money markets
- provide a means for lenders and borrowers to satisfy their short-term financial needs.
- Assets that are bought and sold on money markets are short term, with maturities ranging from a day to a year, and are normally easily convertible into cash.
- The term money market is an umbrella that covers several markets, including the markets for treasury bills and commercial bills
Capital markets
where securities such as shares and bonds are issued to raise medium to long term financing, and where shares and bonds are then traded on the ‘second-hand’ part of the market, (e.g. the London Stock Exchange)
Foreign exchange (forex/FX/currency) markets
global, decentralised market where currencies are traded, mainly by international commercial banks. It determines what the relative value of different currencies will be.
Shares
undated financial assets, sold initially by a company to raise financial capital. Shares sold by public companies or PLCs are marketable on a stock exchange, but shares sold by private companies are not marketable. Unlike a loan, a share signifies that the holder owns part of the enterprise.
Corporate bonds
debt security issued by a company and sold as new issues to people who lend long-term to the company. They can usually be resold second-hand on a stock evchange.
Government bonds (gilts)
debt security issued by a government and sold as new issues to people who lend long-term to the government. They can be resold second- hand on a stock exchange.
Coupon payment
the guaranteed fixed annual interest payment paid by the issuer of a bond to the owner of the bond
Maturity date
the date on which the issuer of a dated security pays the face value of the security to the security’s owners
Describe the relationship between bond prices and interest rates.
- inverse relationship
- if the market interest rate falls, the bond would be worth more, since it carries a higher interest rate than current market conditions.
- Similarly, the bond is worth less is the rate increases. This is because the bond has a lower interest rate than the current market
Bond yield formula
(annual coupon payment/current market price) x 100
Central bank
a national bank that provides financial and banking services for its country’s government and banking system, as well as implementing the government’s monetary policy and issuing currency. The Bank of England is the UK’s central bank.
Commercial bank
a financial institution which aims to make profits by selling banking services to its customers. Also known as a retail or high-street bank.
Investment bank
- a bank which does not generally accept deposits from ordinary members of the general public
- traditional investment banking refers to financial advisory work
- investment banks also deal directly in financial markets for their own accounts
- investment banks help companies, other financial institutions and other organisations to raise finance by selling shares or bonds to investors and to h edge against risks.
Systemic risk
the risk of a breakdown of the entire financial system, caused by inter-linkages within the financial system, rather than simply the failure of an individual bank or financial institution within the system
Credit
when a bank makes a loan it creates credit. The loan results in the creation of an advance, which is an asset on the bank’s balance sheet, and a deposit, which is a liability of the bank
Balance sheet
Balance sheets show the value of a company’s assets, liabilities and owner’s equity during a period of time
Liability
- A liability is something which must be paid. It is a claim on assets
- Liabilities are used to buy assets, and income can be earned from these assets.
- Liabilities are made up of share capital, deposits, borrowing and reserve funds.
Examples of liabilities (3)
- Deposits
- Short and long term borrowing
- Capital (Shareholder equity & Retained profit)
Asset
- An asset is something that can be sold for value.
- Assets are cash, securities and bills, loans and investments.
Profitability
the state or condition of yielding a financial profit or gain
Security
secured loans, such as mortgage loans secured against the value of a property, are less risky for banks than unsecured loans
Zero lower bound
- when the Bank Rate is cut to a very low level, at or close to 0%, there comes a point at which a floor is reached
- once the zero lower bound is reached, it becomes impossible to cut the Bank Rate any further
- this renders the ‘conventional’ expansionary monetary policy of reducing interest rates ineffective
Liquidity trap
- a situation when cutting interest rates below a certain level fails to stimulate consumer spending
- it may be the case that in a deep recession however low the Bank Rate is set, consumers refuse to borrow, and banks are too nervous to lend
- this causes spending in the economy to fall
- a very low Bank Rate traps the economy in situation in which further cuts have little or no effect on AD
Quantitative easing
when the Bank of England buys assets, usually government bonds, with money that the Bank has created electronically
Impacts of quantitative easing (7)
- asset prices increase
- money supply increases
- total wealth increases
- cost of borrowing reduces
- bank lending increases
- spending and income increases
- inflation back at target rate
Evidence that quantitative easing has been successful in the UK (5)
- prevented 2008-09 recession from developing into a depression
- QE in USA stimulated growth in UK
- made it cheaper for government to borrow to finance budget deficit and pay interest on national debt
- cheaper mortgage loans for house buyers
- increased nominal GDP by 6%
Evidence that quantitative easing has been unsuccessful in the UK (7)
- from 2010, growth rate flatlined close to zero
- in 2013 more substantial recovery occurred when QE was not being implemented
- responsible for high inflation rate
- increased bank lending went to big corporations and speculative activity rather than households and small businesses
- house and land prices went up so wealthy better off
- savers and workers contributing to private pensions suffered
- speculative investment into unprofitable businesses (e.g. uber)
Forward guidance
attempts to send signals to financial markets, businesses, and individuals, about the Bank of England’s interest rate policy in the months and years ahead, so that economic agents are not surprised by a sudden and unexpected change in policy
Aims of forward guidance (4)
- increase the credibility of monetary policy through calming uncertainty in financial markets
- this enables households and businesses to feel calmer about their future economic prospects
- allows companies and mortgage borrowers to estimate how long low interest rates will be around
- low short-term interest rates converted into lower long-term interest rates
Limitations of forward guidance (3)
- relies on accurate economic forecasting
- loses credibility if policy changes repeatedly in light of economic shocks
- need to maintain short-term policy flexibility
Financial regulation
involves limiting the freedom of banks and other financial institutions, and of the people they employ, to behave as they otherwise might wish to do
Macroprudential regulation
identifying, monitoring, and acting to remove risks that affect the stability of the financial system
Microprudential regulation
identifying, modifying, and acting to remove risks that affect the stability of banks and financial institutions
Financial policy committee (FPC)
the part of the Bank of England charged with the primary objective of identifying, monitoring, and taking action to remove or reduce systemic risks with a view of protecting and enhancing the resilience of the UK financial system. The committee’s secondary objective is to support the economic policy of the government.
Prudential Regulation Authority (PRA)
the part of the Bank of England responsible for the microprudential regulation and supervision of banks, building, societies, credit unions, insurers and major investment firms. It sets standards for them to follow, and ensures certain capital and liquidity ratios
Financial Conduct Authority (FCA)
aims to make sure that financial markets work well so that consumers get a fair deal, by ensuring that the financial industry is run with integrity and that consumers can trust that firms have their best interests at heart, and by providing consumers with appropriate financial products and services
Aims of the FCA (3)
- protect consumers by securing an appropriate degree of protection for them
- protect financial markets so as to enhance the integrity of the UK financial system
- promote effective competition in the interests of consumers
Why do banks fail? (2)
- loss of capital - If value of assets falls significantly, a bank can run out of capital. It is then bankrupt and must cease trading.
- lack of liquidity - if its liquidity ratio falls too low, a bank may not have enough cash or liquid assets to repay deposits. At this point the bank will need to go to the Bank of England as the lender of last resort.
Moral hazard
the tendency of individuals and firms, once protected against some contingency, to behave so as to make that contingency more likely
Example of moral hazard
- in the 2007-08 financial crisis, banks took too many risks in pursuing the huge profits that lending allows
- they did this because the believed that the Bank of England, in its role as lender of last resort, and the government through its bailouts, would not allow banks to fail
Liquidity ratio
the ratio of a bank’s cash and other liquid asets to its deposits
capital ratio
the amount of capital on a bank’s balance sheet as a proportion of its loans
Systemic risk
a risk that could lead to the collapse of the financial system, due to the inter-linkages in the system, rather than simply the failure of an individual bank or financial institution within the system
Default
the failure or inability to meet the legal minimum requirements of a loan
